Four E’s and an F

Investors have been marking down markets since the start of the year as they have worried about four E’s and an F – or, to be more explicit – the Economy, Earnings, Energy, Elections and the Federal Reserve.

IN BRIEF

In a memorable scene in the movie “Animal House”, Dean Wormer provides the brothers of the Delta fraternity with a sneak peak at their mid-term grades. The letters aren’t pretty, but one feels they were fairly awarded.

Investors have been similarly marking down markets since the start of the year as they have worried about four E’s and an F – or, to be more explicit – the Economy, Earnings, Energy, Elections and the Federal Reserve. However, unlike the Deltas’ report cards these really shouldn’t add up to a failing grade.

First, on the Economy, while there is a great deal of talk about recession, the reality is that the economy isn’t in recession and isn’t close to being in one. Understanding economic momentum in the short run is all about assessing demand across the economy and, in the first quarter of 2016, demand looks solid. Light-vehicle sales and retail sales for January, along with a bounce-back in very low utility spending should allow real consumer spending to rise by 3.0% or more. Government spending should rise, although more modestly as sequester constraints are relaxed, while homebuilding should continue to rise at a close-to-double-digit pace. On the negative side, both investment spending on energy infrastructure and international trade could detract from growth, but the drag should be relatively minor while numbers on industrial production and purchasing manager indices suggest only a limited reduction in inventory growth. In summary, following a slow fourth-quarter, real GDP appears to be tracking close to 2.0% growth for this quarter and should maintain this pace in the year ahead with little real risk of recession.

On Earnings, with 87% of the capitalized value of the S&P 500 reporting, it is clear that operating EPS, (as defined by Standard and Poor’s), will be down year-over-year for the 5th consecutive quarter. However, it is also important to recognize that these numbers are being depressed both by the impact of a high dollar and energy company write-downs. If neither the dollar nor oil prices move from current levels, then earnings should bounce back to solid growth in 2016, particularly in the second half of the year. If the dollar descends from an overvalued position and oil prices rise from an under-valued one, then earnings could well achieve double-digit growth later this year.

On Energy, there are growing signs that Russia and OPEC will try to find some common ground to reduce output in the face of $30 oil. There are many potential problems in coming to an agreement and there is a limit to how high oil prices can go in the short run given still bulging global inventories. However, in the long run, it is clear that, at $30 a barrel, many long-term oil projects like deep-water drilling or the Canadian oil sands, just don’t make economic sense. In time, this reality will cut global output and boost prices. However, until that day, low levels of oil prices should still be seen as a positive for most companies outside of the energy sector.

Many people seem worried about the implications of more radical candidates on both the left and the right.

On the Elections, early primary results and the passing of Justice Scalia have focused renewed attention on the importance of the people’s choice in November. Many people seem worried about the implications of more radical candidates on both the left and the right. However, it is worth reflecting on the fact that the key voters in a general election, unlike the primaries, are moderates and whichever party nominates the candidate seen to be more moderate, should have an advantage in the general election. In addition, while the Republicans could take the White House with a 5% swing and the Democrats could take the Senate with a similar swing in their direction, it would take a huge 15% swing from the 2014 results to cause a change of control in the House of Representatives. In other words, if the Republicans nominate an extremist, the Democrats are likely to hold on to the Presidency. But if a Democrat is elected President, she or he is practically certain to have to work with a Republican House. While the polls seem to favor radicals now, November is less likely to produce radical change.

Finally, on the Federal Reserve, recent statements from Janet Yellen and other Fed officials have made it clear that, while the Fed would like to boost short-term interest rates further, they are likely to take it very slowly in light of the ugly start of the year for financial markets. A rate hike in March seems unlikely but a June rate increase should still be seen as odds on. However, it must be emphasized that the Fed is a little bit like a snail on a coffee break – when they get back to tightening, it will still be at an extraordinarily slow pace relative to previous tightening cycles.

In summary, the economy looks solid, earnings are set for a bounce-back, energy prices will eventually recover, the elections should look less scary in November and the interest rate environment, while not particularly stimulative to the economy, continues to make stocks and other risk assets look attractive relative to bonds and cash. For long-term investors, while stocks have clearly underperformed so far this year, they are, unlike the scholars of Delta Tau Chi, full of promise.

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